What? Me Worry?

Michael L. Gay, MBA, CFP®

During the past decade, investors had an awful lot to worry about. 

From the aftershocks of the 9/11 terrorist attack and an ongoing war in the Middle East, to an unprecedented rise in oil and gas prices, investors had little in the way of good news to think about.

……not to mention:

  • the most severe financial crisis in our history (which included a 46% decline in stock prices)
  • a historic collapse in housing prices
  • a sovereign government that was so incapable of making sensible financial decisions that its debt was downgraded
  • historic U.S. federal deficits

And today, heading into 2013, things are no different.  The media has peppered us with headlines of a looming “fiscal cliff” and the related possibilities of large tax increases, massive cuts in federal spending, and a subsequent recession. 

…..not to mention:

  • the possibility of war or a potential nuclear event with Iran
  • the potential of increased inflation caused by the Federal Reserve’s stimulus programs
  • the reality of an ongoing financial crisis at home and in Europe
  • repeated warnings from the financial press of an inevitable collapse in the dollar

And, once again, investors have little in the way of good news to think about.

Which makes me think that the next decade may very well be just like the last one.  Which is to say:

A very good decade for passive investors. 

You see, despite all the crises, despite all the worrisome possibilities, and despite all the “risk on, risk off” talking points raised by Wall Street and its agents in the media, investors who managed to ignore all the noise fared quite well.

Because during the past decade (the 10 years ending 8/31/2012), an investor who held a simple buy-and-hold portfolio of 10 common asset classes earned an average annual return of 10.8%.  That’s a 160% increase in wealth during what was arguably one of the most volatile decades since World War II.

And all that was required of investors was a bit of discipline.  The discipline to create a goals-based allocation and stick with it through thick and thin, ignoring (or, at least, not acting upon) pretty much everything reported by Wall Street and its agents in the media.

So the next time you are tempted change your portfolio based on the latest bit of commentary about the “fiscal cliff” or who won the election (or any other bit of headline news), take a deep breath and remind yourself that living with market volatility is the price we pay for earning the return we need to achieve our most important financial goals. 

Such is the nature of risk.  And without risk there would be no reward.

How Your Political Views Can Affect Your Portfolio

An excellent article from CBS Marketwatch re: the dangers of letting politics impact your portfolio decisions.

Read the full article here.

The Soothsayers are Few and Far Between

Michael L. Gay, MBA, CFP®

The question is decades old: Can professional money managers consistently pick stocks that outperform the broad stock market averages – as opposed to just being lucky now and then?

Countless studies have addressed this question, and most have concluded that very few managers have the ability to beat the market over the long term. Nevertheless, researchers have been unable to agree on how small that minority really is, leaving the industry to debate whether it makes sense for some investors to try to beat the market by buying shares of actively managed mutual funds.

Recently, a new study was concluded which used a far more sophisticated statistical analysis than we’ve seen in the past. The study, “False Discoveries in Mutual Fund Performance: Measuring Luck in Estimating Alphas”, uses a sensitive statistical test (the False Discovery Rate) borrowed from astrophysics and chemistry, among other scientific communities.

In effect, the method is designed to simultaneously avoid false positives and false negatives — in other words, to avoid concluding that something is statistically significant when it is entirely random, or that something is random when it is statistically significant. Both of these problems have hampered many previous studies of mutual funds.

So, what happens when you apply the False Discovery Rate test to 30 years of data (and almost 2,100 actively managed funds)?  The researchers – Professors Barras, Scaillet, and Wermers – found a marked decline over the last two decades in the number of fund managers able to pass the test. They found, for example, that 14.4% of managers had genuine stock-picking ability back in 1990; by 2006, however, they found that the proportion had declined to just 0.6% – statistically indistinguishable from zero.

This, while not surprising to those of us who have spent years standing passionately behind our “passive beats active” mantra, is yet another stunning blow to the financial services industry. It is also, one can hope, a wake-up call for those investors who still believe in active management; perhaps they will finally realize that the gamble they are taking, at significant expense, has an expected return of less than ZERO.

Why the decline?

Professor Wermers says he and his colleagues suspect several causes, including high fees and increasingly efficient markets. Whatever the cause(s), the investment implications of the study are the same: buying and holding low cost passively-managed funds is the only rational choice for most, if not all, equity investors.

 The financial services industry will, of course, continue to promote its rock-star money managers, doing all they can to convince you (and themselves) that extraordinary skill (rather than luck) is the reason for their 5-Star rating.  But, as we now know with certainty, it’s luck – not skill – that most often results in market-beating performance.  As this study makes perfectly clear: The soothsayers are, indeed, few and far between.

The Top Ten Money Excuses

Jim Parker, Vice President, Dimensional Fund Advisors

Human beings have an astounding facility for self-deception when it comes to our own money. We tend to rationalize our own fears. So instead of just recognizing how we feel and reflecting on the thoughts that creates, we cut out the middle man and construct the façade of a logical-sounding argument over a vague feeling.  These arguments are often elaborate, short-term excuses that we use to justify behavior that runs counter to our own long-term interests.
Here are ten of these excuses:

1) “I just want to wait till things become clearer.”

It’s understandable to feel unnerved by volatile markets. But waiting for volatility to “clear” before investing often results in missing the return that can accompany the risk.

2) “I just can’t take the risk anymore.”

By focusing exclusively on the risk of losing money and paying a premium for safety, we can end up with insufficient funds for retirement. Avoiding risk can also mean missing an upside.

3) “I want to live today. Tomorrow can look after itself.”

Often used to justify a reckless purchase, it’s not either-or. You can live today and mind your savings. You just need to keep to your budget.

4) “I don’t care about capital gain. I just need the income.”

Income is fine. But making income your sole focus can lead you down a dangerous road. Just ask anyone who recently invested in collateralized debt obligations.

5) “I want to get some of those losses back.”

It’s human nature to be emotionally attached to past bets, even losing ones. But, as the song says, you have to know when to fold ’em.

6) “But this stock/fund/strategy has been good to me.”

We all have a tendency to hold on to winners too long. But without disciplined rebalancing, your portfolio can end up carrying much more risk than you bargained for.

7) “But the newspaper said…”

Investing by the headlines is like dressing based on yesterday’s weather report. The news might be accurate, but the market usually has reacted already and moved on to worrying about something else.

8) “The guy at the bar/my uncle/my boss told me…”

The world is full of experts, many who recycle stuff they’ve heard elsewhere. But even if their tips are right, this kind of advice rarely takes your circumstances into account.

9) “I just want certainty.”

Wanting confidence in your investments is fine. But certainty? You can spend a lot of money trying to insure yourself against every possible outcome. While it cannot guard against every risk or possible outcome, it’s cheaper to diversify your investments.

10) “I’m too busy to think about this.”

We often try to control things we can’t change—like market and media noise—and neglect areas where our actions can make a difference—like the costs of investments. That’s worth the effort.

Given how easy it is to pull the wool over our own eyes, it can pay to seek independent advice from someone who understands your needs and circumstances and who holds you to the promises you made to yourself in your most lucid moments.


Call it the “no more excuses” strategy.


Low Return Environment?

Michael L. Gay, MBA, CFP®

John Bogle (of Vanguard fame) has a nice, simple model for explaining stock market returns. In his model, market returns can be attributed to three factors:

1. Earnings Growth
2. Dividends
3. Changes in the P/E ( Price/Earnings) Ratio

According to Bogle, the stock market has earned an average annual return of about 9.6% during the past century. That return included earnings growth of 5%, dividends of 4.5%, and a slight increase in the P/E ratio which accounted for the remaining 0.1%.

The question, of course, is whether or not that 9.6% historical average is likely to hold for the foreseeable future. While I’d be willing to bet that the next century will see similar average returns, I’m not willing to bet that the next decade will be quite so rosy. I hope I’m wrong, of course, but each of the three variables appears to be subject to some very strong headwinds that are likely to result in lower-than-average returns for the foreseeable future.

Earnings Growth. Globally, earnings growth is likely to be muted for quite some time as the developed economies attempt to work through the recent financial crises. As Bill Gross noted in an article entitled “You Don’t Get the New Normal”, investors need to learn to expect “half-size economic growth induced by deleveraging, reregulation, and deglobalization. People, companies and countries shedding their debts (will lead to) years of slow economic growth and meager investment returns.”

Dividends. Dividends historically have accounted for a large percentage of stock returns. Unfortunately, dividend yields have been steadily declining. In the early part of the 20th century, dividend yields approached 6%. In the latter part of the 20th century, dividend yields declined to less than 3%. And, as of this writing, dividend yields are averaging around 2%.

P/E Ratios. The P/E Ratio accounts for what Bogle calls the “speculative” component of stock returns. It represents the price that investors are willing to pay for a dollar of earnings. Historically, the P/E ratio has averaged about 15 times earnings. In other words, if a company earns $1 per share, investors have been willing to pay about $15 for that company’s stock.

During periods of market optimism P/E ratios tend to rise as investors become willing to pay more for a dollar of earnings. During periods of market pessimism, P/E ratios tend to fall as investors flee the market.

Currently, the P/E ratio stands at about 16, somewhat higher than the historical average, suggesting that any significant growth in the ratio is likely to be short-lived.

So, let’s take what we know and plug it into Bogle’s formula. Earnings are currently growing at approximately 2.5% annualized. Let’s (optimistically) assume – despite our nation’s trillion-dollar deficits and the reckless policies being forced upon our nation by the federal government – that the economy finds a way to get closer to its historical average and grow by 4% per year. Let’s further assume that dividend yields remain at their current 2% level (since there don’t seem to be any incentives for corporations to increase their dividends, and the only other way to get an increased yield would be to have a decrease in stock prices). So, ignoring the P/E Ratio for a moment, we’re optimistically projecting stock market returns of 6% per year (4% earnings growth plus 2% dividends) – well below Bogle’s historical average of 9.6%.

Now let’s throw the P/E ratio into the mix.

If the P/E ratio expands, future market returns could be higher than our estimate. If it contracts, future market returns could be lower than our estimate. Unfortunately, there does not appear to be much room for sustainable P/E expansion. As I noted earlier, the P/E ratio for the S&P 500 is currently around 16, slightly above its historical average of 15. But the Shiller P/E, which is probably a better measure of Bogle’s “speculative component” because it uses average earnings from the past 10 years, is currently around 23 – well above its historical average of 16.4.

This analysis is consistent with several recent – and more scientific – studies that have attempted to estimate likely future long-term market returns.  For example, in a recent research paper entitled “The Expected Real Return to Equity”, Missaka Warusawitharana (no, I can’t say it either), an economist on the Federal Reserve’s Board of Governors, concludes that current data indicates future average returns are likely to be 1.5% – 3% lower than historical averages.  These results are consistent with several other peer-reviewed research studies.

All of this information suggests that any significant market rallies are likely to be short-lived. It also suggests that currently there is significantly more downside risk in the market than there is upside risk.  Of course, our crystal ball is no better than anyone else’s: Whether the markets return an average of 6% or 9.6% or 12% per year for the next decade is anybody’s guess.  But the smart money, it would seem, isn’t betting on “Dow 20,000″ anytime soon.  $$

Controlling What’s Controllable

Michael L. Gay, MBA, CFP®


Active (Investment) Management is the practice of trying to beat the market by attempting to identify “great” stocks or mutual funds, or by attempting to time exactly when to get in to, or out of, the market. It is the antithesis of Passive Management, which is a buy-and-hold strategy that uses low-cost index funds to simply match the returns of various asset classes. Compared to Passive Management techniques, Active Management is riskier and almost invariably produces lower long-term returns. If you study the objective research, you can come to no other conclusion. As Charles Ellis so eloquently stated, Active Management is a Loser’s Game.

Yet, despite all the evidence, and despite all the harm being done to the typical investor’s portfolio, there is still more money invested using active techniques than there is using low-cost index funds. The question is: “Why?” Why do so many investors pursue the failed practice of active investment management? Certainly, many are simply uninformed or misinformed: There is a powerfully profitable alliance between Wall Street and the popular press which continues to disseminate mountains of misleading investment pornography. But even informed investors – investors who have read the research – often ignore the facts, pursuing active strategies when they know they are likely to make less money than they would if they had invested in simple low cost index funds. But, again, the question is: “Why?”

For some, whether they admit it or not, investing is a form of gambling. Gambling and the tendency to assume unnecessary risks for highly unlikely rewards appears to be a basic human trait. Winning (even if it is by luck) fuels the ego and many investors appear to be happier with an underperforming portfolio that has an occasional “home run” than they are with a portfolio that earns relatively consistent returns but offers little potential for abnormally high gains.

For others, it’s a matter of “belief perseverance” – the tendency for people to hold on to their beliefs even in the presence of contradictory evidence. Not only are people reluctant to search for evidence that contradicts their beliefs, they will most often treat any evidence they do find with excessive skepticism. To some, it must seem impossible that something as seemingly simple (and boring) as indexing could reign supreme over something as complex (and intellectually stimulating) as active management.

Of course, there are many other behavioral issues which cause investors to favor the complex over the simple, and to actively manage their portfolios when the best course of action is to index. Examples are plentiful. There’s self-attribution bias – the tendency for investors to attribute their successes to their own skills (rather than luck) and to attribute their failures to factors beyond their control. There’s overconfidence – the tendency for investors to believe they have keener investment insights than everyone else.

There’s hindsight bias – the tendency for investors to see historical peaks and troughs as obvious and meaningful (when they weren’t and aren’t). And there’s familiarity bias – the tendency to invest in what we know, thus giving ourselves a false sense of control (this is a particular problem for Michiganders who seem to love to put their portfolios at unnecessary risk by owning shares of either Ford or GM). Investors are also prone to extrapolation – the tendency to perceive historical “patterns” as trends when, in fact, they are nothing but random noise.

All of these behavioral issues serve to cloud the reasoning of otherwise prudent investors and steer them away from the benefits of indexing.

But I think, perhaps, the most powerful behavioral issue that perpetuates the active management myth (other than, perhaps, the popular press) is our unrelenting desire to feel in control – even when facing uncontrollable random events (such as the performance of the stock market). Humans are not very good at statistically understanding the world around them. Our brains are programmed to see trends where none exist, to draw conclusions based on incomplete data, and to dismiss the consequences of certain risky behaviors. To most, randomness does not look random (thus the popularity of statistically meaningless “5 Star” rating systems).

So, when someone comes along offering a way to “control” one of the most uncertain aspects of investors’ lives (i.e., stock market performance), active investors gain a great deal of comfort – even when that comfort is a very risky illusion.

In their search for control, and whether they realize it or not, investors who use active techniques actually add more uncertainty to their portfolios; because with active management comes the additional (and almost guaranteed) risk of underperforming the markets. And this underperformance risk can be devastating – especially if it happens to coincide, for example, with an investor’s planned retirement date. A single year of underperformance can easily wipe out a decade of market-beating gains.

Thankfully, trying to control portfolio performance via active management is not a necessary ingredient for investing success. What is necessary, however, is recognizing (and acting upon) what we can control.

If we define success in investing as being able to use our portfolios to meet our most important financial goals, then investors have control over just two variables: the amount of market risk they expose themselves to, and their cash flows (the amount of money they spend, and the amount of money they save). Assuming a diversified portfolio, risk is controlled via asset allocation. The asset allocation decision, in turn, is determined largely by the cash flow variables – planned levels of spending and planned levels of savings.

All else being equal, the more you plan to spend (or the less you plan to save), the more risk you will need to take to meet your financial goals.

So, while investors cannot control the timing of market returns, or whether or not their portfolios will beat the market, they can control the overall level of market risk that they need to subject themselves to: Not by looking for stock-picking or market-timing gurus but, rather, by simply changing their spending and/or savings habits.

Again, the less you spend (or the more you save), the less risk you will need to take to meet your goals. Conversely, if you plan to spend a lot during retirement and are unwilling to maximize your savings, you will probably have to take more risk in your portfolio to try to earn the returns that will be necessary to support your lifestyle.

In other words, closely examining your spending and savings habits (and adjusting your portfolio’s allocation accordingly) can do far more to help ensure you’ll meet your financial goals than trying to identify the next market “guru”, or waiting for the next “perfect time” to reinvest your money. The former – controlling what you can control (i.e., how much you save, how much you spend and your overall allocation) – has an almost 100% chance of succeeding. The latter – trying to control what you can’t (i.e., the timing of portfolio returns via active management) – has an almost 100% chance of failing. $$

The Greatest Hits of Investing

In this article, Brad Steiman of Dimensional Fund Advisors demonstrates how “ . . . investing is like music in that true classics stand the test of time and remain relevant long after they were initially composed.” [Download Article]